Stocks: The Start of Something Big?

S&P starts sifting for investing opportunities that are likely to emerge once the post-Feb. 27 dust settles

The 3.46% drop in the S&P 500 on Feb. 27 was eye-catching, but it certainly was not record-setting. In fact, it was only No. 31 on the one-day "hit" parade since 1950. The first trading day's decline after September 11 was bigger, as was the fallout from Long-Term Capital Management's implosion in 1998. Of course, the mother of all single-session slumps occurred on Black Monday, Oct. 19, 1987.

What triggered the major decline? Many things, in our opinion, which essentially related to the prospects for a worldwide economic slowdown. In the U.S., investors had been barraged by a battery of less-than-rosy economic reports and comments, including the current debate on the impact from submerging subprime loans; last week's larger-than-expected rise in the core consumer price index; a warning by former Fed Chairman Alan Greenspan about the possibility the U.S. economy could slip into recession by yearend; and a durable-goods orders report that was substantially weaker than anticipated.

Fear of a sharp revision to the preliminary fourth-quarter 2006 real GDP report was realized, as the number was lowered to 2.2% from 3.5%.

Unfazed Fundamental Forecasts

When China was added to our more parochial ponderings, investors began to worry that the legs supporting worldwide economic growth had become less stable than earlier believed. Investors are well aware of the Chinese government's attempts to slow economic growth through interest rate increases and higher bank reserve requirements, but when the Shanghai market tumbled more than 9% on Feb. 27, it became the tipping point for worldwide markets as investors, we think, worried that the engine of global economic growth was shifting into lower gear.

Investors shouldn't be too surprised by the market's sharp decline, however. The S&P 500 index posted positive performances in each of the last eight months (and was on the way to recording its ninth). This string of uninterrupted strong numbers is less common than investors might think. What's more, the S&P 500 had not experienced a 2% one-day decline since May 19, 2003. It enjoyed 949 days of relatively smooth sailing, which was the longest span since 1950. The second-longest streak was 807 days from Aug. 21, 1975 through Oct. 30, 1978.

In addition, Mark Arbeter, S&P's chief technical strategist, warned that the three major U.S. markets, as well as at least eight of the 10 S&P 500 sectors, were in severely overbought conditions, by his analysis, and that divergences were emerging.

The real question now is, how long will this downturn last? In the short term, we believe the answer lies in the technical action of the market. In other words, the market will stop declining when it wants to, and we will take our cues from its near-term fluctuations. In all, Arbeter believes we could see a correction of between 5% and 7% in the S&P 500.

Abounding Opportunities?

Longer term, however, S&P Equity Strategy believes the underpinnings for equity price advances remain intact. Our yearend forecast for the S&P 500 remains at 1,510, for an expected 6.5% price gain from 2006's closing price of 1,418.30. S&P Economics is calling for a 2.4% advance in U.S. GDP this year, representing a healthy component of the 3.3% growth anticipated in worldwide GDP. S&P equity analysts are still projecting an 8% rise in S&&P 500 operating earnings during 2007, and as a result of the recent decline in prices, valuations are even more attractive than before, in our opinion.

Based on trailing 12-month earnings, the S&P 500 is currently trading at a 19% discount to the average price-to-earnings ratio since operating earnings were first captured by S&P. The p-e on projected 2007 earnings now stands at 14.8. From an "as reported" standpoint, the trailing p-e is at a 25% discount to the average since 1988 and the forward p-e is 30 basis points away from the average trailing p-e of 15.7 since 1935.

One man's trash is another man's treasure.

In order to unearth some treasures, we have to sift through those sectors and subindustries that were trashed in the recent carnage. Even though all 10 sectors within the S&P Composite 1,500 index (consisting of the S&P 500, S&P MidCap 400, and S&P SmallCap 600 indices) posted declines, the levels of retreat were fairly uniform. Decreases ranged from –2.7% for the health-care sector to –4.2% for the materials group.

Sifting Through the Wreckage

In addition, all 138 subindustry indices posted declines on the day, from –1.5% for brewers ("When the going gets tough, the tough go eating, smoking, and drinking!") to –6.8% for steel companies.

So, which industries and companies will likely recover the most? Let the sifting begin. The accompanying table lists the 10 subindustry indexes that were hit hardest on Feb. 27, but have positive 12-month forward fundamental outlooks by S&P analysts, as well as component companies with either 5 STARS (strong buy) or 4 STARS (buy) recommendations from S&P analysts.

While the long-anticipated and much-needed correction may be at hand, S&P believes that once the dust settles, a clearer array of buying opportunities may emerge.

S&P 1,500 Subindustry Favored component companies
Apparel, Accessories & Luxury Goods Coach (COH; 5 STARS), Quiksilver (ZQK; 5 STARS)
Asset Mgmt. & Custody Banks Franklin Resources (BEN; 5 STARS)
Broadcasting & Cable TV Comcast (CMCSA; 4 STARS)
Commercial Printing R.R. Donnelly (RRD; 4 STARS)
Computer Storage & Peripherals Western Digital (WDC; 5 STARS)
Gold Newmont Mining (NEM; 4 STARS)
Human Resource & Employ. Svcs. Robert Half Intl. (RHI; 5 STARS)
Industrial REITS AMB Property (AMB; 4 STARS)
Integrated Oil & Gas Exxon Mobil (XOM; 5 STARS), Chevron (CVX; 4 STARS)
Investment Banking & Brokerage E*Trade Finl. (ETFC; 5 STARS), Goldman Sachs (GS; 5 STARS), Lehman Bros. (LEH; 5 STARS), Merrill Lynch (MER; 5 STARS)
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